Wednesday, September 08, 2010

Was Friedman Right on Markowitz?

Harry Markowitz’s 1950 dissertation on the portfolio mathematics was to become the basis for his Nobel Prize in 1990. At the time the subject seemed to his dissertation advisor Milton Friedman to contain a too much statistics as opposed to economics, because it spent a lot of time on algorithms to determine the portfolio weights for the efficient frontier. Nothing stings like the lukewarm approval of men we respect, and so in a scene surely envied by many a thesis advisee, Markowitz noted in his Nobel lecture:

When I defended my dissertation as a student in the Economics Department of the University of Chicago, Professor Milton Friedman argued that portfolio theory was not Economics, and that they could not award me a Ph.D. degree in Economics for a dissertation which was not in Economics. I assume that he was only half serious, since they did award me the degree without long debate. As to the merits of his arguments, at this point I am quite willing to concede: at the time I defended my dissertation, portfolio theory was not part of Economics. But now it is.

It is understandable that Friedman found the the nuts and bolts of generating the efficient frontier of little relevance to economics, as with hindsight the efficient frontier in return-standard deviation space has nothing to do with risk according to the the latest general equilibrium models (or really, any latest model). Markowitz’s big idea was merely the benefits of diversification, which is a good idea, but simple enough and hardly novel (the idea was mentioned in the Bible and by Shakespeare--but that didn't stop Telluride Asset Management from suing to keep me from applying the top-secret idea of mean-variance optimization).

As the vast majority of Markowitz's early work focused on algorithms that turned into a dead end, I think Friedman’s intuition has been vindicated: the efficient frontier, and therefore how to get there, is irrelevant.

There's always the hope that, like Wile's proof of Fermat's Last Theorem, a complex three-day proof exposes an insight of incredible depth and profundity, an idea that that requires some specialized technical knowledge, as this would vindicate the method of those with their technical knowledge. Great classical music is an example of something that validates rigorous study because if you study music rigorously you appreciate it more. Alas, it rarely works that way.

Bottom line: diversification is still good, but volatility is not priced risk (and Friedman, as usual, was right).